Can I Use My 401(k) to Invest in Real Estate?

Investing in real estate with 401(k) funds differs from direct investment, as 401(k)s are designed for traditional assets like stocks and bonds, not direct property purchases. To use these retirement savings for real estate, an indirect approach, typically a rollover into a specialized account, is necessary. This method allows individuals to leverage their retirement funds for property investments and portfolio diversification.

Rolling Over Your 401(k) for Real Estate Investment

The IRS does not permit direct 401(k) investment into real estate. Instead, funds must first be transferred into a Self-Directed Individual Retirement Account (SDIRA). An SDIRA functions like a traditional IRA but offers greater control over investment choices, allowing for alternative assets like real estate within a tax-advantaged retirement structure.

There are two primary methods for moving funds from a 401(k) to an SDIRA: a direct rollover or an indirect rollover. A direct rollover is the preferred and simpler method, where funds are transferred electronically or by check directly from the current 401(k) administrator to the SDIRA custodian. With a direct rollover, the funds never pass through the account holder’s hands, avoiding potential tax withholdings and penalties.

Conversely, an indirect rollover involves the 401(k) administrator issuing a check directly to the account holder. The individual then has 60 days from the date of receipt to deposit these funds into the new SDIRA. Failure to complete the deposit within this 60-day window can result in the entire amount being treated as a taxable distribution, potentially incurring income taxes and a 10% early withdrawal penalty if the account holder is under age 59½. Furthermore, a mandatory 20% federal income tax withholding applies to indirect rollovers, which must be made up by the account holder to fully fund the SDIRA.

The rollover process begins with selecting a reputable SDIRA custodian. After establishing the SDIRA, the account holder contacts their 401(k) plan administrator to initiate the transfer. The custodian facilitates the fund transfer and ensures compliance with IRS regulations for permissible investments.

Custodians charge various SDIRA fees, including a one-time setup fee, annual maintenance fees, and transaction-specific fees. Setup fees range from $50 to $300, and annual fees can be flat or asset-based. Transaction fees may apply for purchases, sales, wire transfers, and earnest money deposits, making it important to understand the full fee schedule.

Individuals with a 401(k) from a former employer find rollovers straightforward. However, if the 401(k) is with a current employer, the ability to roll over funds depends on the plan’s specific rules, as some plans do not permit in-service withdrawals. It is important to consult with the current plan administrator to determine eligibility and the necessary paperwork for such a transfer.

Types of Real Estate Investments Allowed

A Self-Directed IRA offers a broad spectrum of real estate investment opportunities, allowing diversification beyond traditional securities. These accounts can hold various tangible properties and real estate-related assets, provided they are held strictly for investment purposes.

Common real estate assets allowed within an SDIRA include residential properties (single-family homes, multi-family dwellings) for rental income or resale, commercial properties (office buildings, retail spaces, industrial warehouses), and raw land for appreciation or future development.

Beyond direct property ownership, an SDIRA can invest in mortgage notes, where the IRA receives principal and interest payments from real estate-secured loans. Investments in private real estate funds or syndications, where the IRA acts as a passive investor, are also common. Real Estate Investment Trusts (REITs), while often held in traditional brokerage accounts, can also be held within an SDIRA.

Understanding Prohibited Transactions

Investing in real estate through an SDIRA involves strict IRS rules to prevent self-dealing and conflicts of interest. These regulations prohibit certain transactions involving the IRA and “disqualified persons.” Adhering to these rules is important to maintain the IRA’s tax-advantaged status.

A disqualified person includes the IRA account holder, their spouse, and their lineal ascendants (parents, grandparents) and descendants (children, grandchildren, and their spouses). Also included are any entities (corporations, partnerships, or trusts) in which these individuals hold a 50% or greater interest, and fiduciaries or anyone providing services to the IRA, such as an accountant or financial advisor.

Prohibited transactions include activities that could personally benefit a disqualified person from the IRA’s assets. Examples are selling or buying property to or from your SDIRA. Using SDIRA-owned real estate for personal enjoyment, such as living in a rental property or using a vacation home, is strictly forbidden. Providing services to an SDIRA-owned property, like performing repairs or maintenance yourself, is also a prohibited transaction.

Personally guaranteeing a loan taken out by the SDIRA to acquire property is another prohibited transaction. Loans to an SDIRA for real estate must be non-recourse, meaning the lender can only pursue the property itself in case of default, not the IRA owner’s personal assets. Any transaction allowing a disqualified person to receive a direct or indirect personal benefit from the SDIRA’s assets, beyond the investment’s return to the IRA, is prohibited.

Violating these rules carries severe penalties. If a prohibited transaction occurs, the entire IRA is immediately disqualified, and all its assets are considered a taxable distribution as of the first day of the tax year in which the transaction occurred. This means the full value of the IRA becomes taxable income, and if the account holder is under age 59½, an additional 10% early withdrawal penalty may apply. An excise tax may also be imposed on the amount involved in the prohibited transaction.

Tax Implications of Real Estate in a Self-Directed IRA

A Self-Directed IRA offers tax advantages for real estate investments, but specific tax considerations arise, primarily Unrelated Business Taxable Income (UBTI) and Unrelated Debt-Financed Income (UDFI). Understanding these concepts is important. Income generated within an SDIRA grows tax-deferred or tax-free, depending on whether it is a traditional or Roth SDIRA.

UBTI is income from a trade or business regularly carried on by a tax-exempt entity, like an IRA, that is not substantially related to its exempt purpose. While passive rental income from real estate is exempt, active business operations within the IRA, such as running a hotel or frequent property flipping, could generate UBTI. This tax prevents tax-exempt entities from having an unfair advantage over taxable businesses.

UDFI is a specific type of UBTI that arises when real estate within an SDIRA is purchased using debt financing, such as a non-recourse mortgage. If an SDIRA uses borrowed money to acquire or improve real estate, the portion of the income or gain from that property attributable to the debt is considered UDFI and is subject to UBTI. This applies to rental income and capital gains upon sale, proportionate to the amount of debt used.

The calculation of UBTI involves determining gross income from the unrelated business or debt-financed property, less directly connected expenses. If net UBTI exceeds $1,000 in a year, the SDIRA must file IRS Form 990-T, Exempt Organization Business Income Tax Return. UBTI tax rates are trust tax rates, which can be progressive and reach the highest marginal rate at relatively low income thresholds.

It is the responsibility of the IRA owner, not the custodian, to determine if UBTI applies and to file Form 990-T if necessary. Any taxes due on UBTI must be paid from the SDIRA’s funds, not from personal funds. While UBTI can impact the overall profitability of a leveraged real estate investment within an SDIRA, the remaining income that is not subject to UBTI continues to benefit from the IRA’s tax-deferred or tax-free growth.